Business.view

Heads I win, tails you lose

Why Wall Street needs a new social contract

EVER since Rolling Stone magazine described Goldman Sachs in July as a “a great vampire squid wrapped around the face of humanity, relentlessly jamming its blood funnel into anything that smells like money,” the investment bank has emerged as the favourite piñata for anyone who wants to give Wall Street a mighty thwack. Lloyd Blankfein, the investment bank's chief executive, may be right, as he recently told The Economist, that vampire squids, which really do exist in the depths of the ocean, are “small and harmless”. Yet his firm and the industry of which it is now the reluctant face have a real image problem, which they need to deal with before it turns into something nastier.

Among the wilder allegations the industry is facing is Michael Moore's claim in his new film, “Capitalism: A Love Story”, that a deliberate Wall Street conspiracy resulted in a $700 billion raid by the banks on the Treasury (otherwise known as the Troubled Asset Relief Programme). Mr Moore's film includes a stunt in which he attempts a citizen's arrest of Mr Blankfein over this “crime”.

Winners take all

Ironically, investment banking's image has been further stained by something that would have delighted many panicked observers in the aftermath of the collapse of Lehman Brothers last September: the bumper profits announced by Goldman Sachs—$3.2 billion in the most recent quarter—and some other financial giants of late. Rather than being seen as welcome evidence of the recovery of the financial system, these have instead prompted widespread condemnation.

It is not the fault of Goldman Sachs that it is now working in (at least temporarily) a less competitive market, thanks to the demise of Lehman and the merging of Bear Stearns and Merrill Lynch into JPMorgan Chase and Bank of America respectively. Part of its profits reflect the higher fees its bigger market share allows.

Equally, much of the outrage over bonuses is unjustified. People who create wealth are entitled to be rewarded for their efforts. Certainly, bonus schemes need to be redesigned to reflect the fact that the old schemes encouraged too much short-term risk-taking—something that is clearly in the interests of shareholders. Yet Jeffrey Gordon, a professor of law at Columbia University, points out that Goldman set aside 50% of its profits for bonuses, in keeping with previous years. “There is no evidence that Goldman's management has overreached shareholders in making this decision, or that bondholders have any basis for objection in light of their covenants or other expectations,” he says.

Nonetheless, many things changed when the taxpayer bailed out the financial system last year, including Goldman Sachs (despite its implausible protests that it would have survived without government intervention). As Mr Gordon says, “In a very real sense, Goldman's profits are attributable to the government's many actions, meaning taxpayer investment in the financial sector generally and in Goldman specifically.”

Even if Goldman has repaid the $10 billion (plus fees and dividends) in TARP money it says it did not want to take in the first place, it continues to benefit from, among other things, the government's ongoing offer of loans—whether it accepts them or not—and the revival in capital markets sparked by the government's decision to pump money into the financial system.

Shareholders and bondholders of the firms that survived the meltdown were the biggest winners from the government rescue—more so than the employees

The shareholders and bondholders of those financial firms that survived last year's meltdown have been the biggest winners from this government rescue—bigger even than the employees of these firms. Goldman's share price is over 300% higher than in November last year, for example. It is they who should be the primary focus of taxpayer outrage (even if, thanks to the institutions that own shares to finance future pensions, these taxpayers and shareholders are to some extent the same people).

The best solution would have been for the government to have taken an equity or equity-related stake in every financial firm it helped when it bailed out the system last year. Compared with the dividends and warrants associated with the TARP, this would have given the taxpayer a far greater exposure to the upside to the rescue, and would surely have eased some of the public outrage today.

The Treasury was unwilling to be seen taking an equity stake in any bank unless there was absolutely no alternative—as in the case of Citigroup, of which it now owns 30%. Apparently this was because the treasury secretary at the time, Hank Paulson, a former boss of Goldman, did not want to be seen as a nationaliser. As a result, the taxpayer has ended up nationalising both the worst of the banks it helped and some of the system's most toxic assets, while missing out on much of the profit it could have made from a stake in the better firms that were saved.

What would Warren Buffett do?

Warren Buffett would not have made such a mistake, as he showed when he invested in Goldman Sachs soon after the government did—negotiating a 10% dividend on $5 billion of preferred stock with warrants giving him the right to invest a further $5 billion in Goldman shares at what now looks like the bargain price of $115 each. Surely Mr Paulson could have negotiated far better terms than Mr Buffett. No wonder the public feels that Wall Street's current fortunes are a case of heads I win, tails you lose. The question is, what can be done about it?

The opportunity to take an equity position at a bargain price has been missed. A windfall-profit tax is easier to justify in this case than it usually is—though there currently seems little appetite for one in Washington, and such taxes can distort banks' behaviour in unpredictable and counterproductive ways.

The more politically palatable options—regulating bonuses and cracking down on Wall Street's risk-taking activities—could also make matters worse. Last week Citigroup was forced to sell Phibro, its commodity-trading arm, at an absurdly low price because of the political storm around the $100m bonus paid to its boss, Andrew Hall. This does not look like a good outcome for Citi's part-owner, the taxpayer.

Nonetheless, if public anger continues to grow, politicians in Washington, DC, are more likely to impose burdensome regulation on financial firms. If they are wise, Goldman and its peers will do something soon to try to calm the public mood.

Though it will not do much to help taxpayers, the much-discussed idea of Goldman and others donating some of their profits to charity would be a start. This would be in keeping with the fine philanthropic tradition of Goldman in particular, which most recently has been funding an impressive “10,000 Women” initiative to send female entrepreneurs in developing countries to business school. Yet to be viewed as a genuine effort to repay the charity investment banks have received, the gifts would need to be large: in the billions of dollars, not the tens of millions.

Shareholders would be wise to support such donations, if management proposes them. Shareholders can also play a constructive role in changing the mood by doing a better job of requiring management to ensure that bonuses are better designed, ideally mostly in the form of restricted stock that does not vest for several years.

As part of establishing the new “social compact” that Larry Summers, Barack Obama's chief economic adviser, says is urgently needed, Wall Street firms should also stop lobbying against the proposed Consumer Protection Agency, and instead support efforts to ensure it works. As Mr Summers mildly put it, given the help Wall Street firms have received from the taxpayer, some of their behaviour lately has been “a bit rich”.